Private Foundations FAQ

Frequently Asked Questions about Private 501c3 Status

1. What is a private foundation, or family foundation? Technically, it is a not-for-profit entity that can be controlled by a person, family or business. Sometimes private foundations are referred to as ‘family foundations’. They are organized exclusively for charitable, educational, religious, scientific and literary purposes under Section 501(c)(3) of the IRS Code. The foundation must be officially recognized by the IRS in order for contributions to it to be tax deductible. In practice, a private foundation is a unique planned giving vehicle that fosters family involvement, provides significant control over assets and giving, and allows donors to receive an immediate tax deduction for charitable donations that are made in the future.

2. What are the benefits of a private foundation?

Family legacy. A private foundation establishes a legacy of giving that can carry the family name, supports causes that are important to you, and promotes charitable activities into the future.

Control. Private foundations provide the greatest control of any planned giving vehicle. You decide which charities to support and how the assets are invested. You also have great latitude as to the types of assets you can donate to the foundation.

Family involvement. A private foundation enables you to involve the family in philanthropy and pass values on to future generations.

Current tax deduction for future grants. You can take an immediate tax deduction for contributed assets, even if the foundation does not make charitable grants until a later date. You are also able to remove taxable assets from your estate, without incurring capital gains taxes. (Consult with your tax advisor.

3. How does a private foundation compare to a Donor Advised Fund? The difference is mainly in control and flexibility. With a private foundation, the donor retains control over charitable donations and other disbursements. Foundations can hire staff, reimburse expenses, set up structured giving programs such as scholarships, and make grants directly to individuals in need. In addition, donors can contribute a much wider variety of assets to fund the foundation, such as “144” restricted stock, and the founder retains control over how the assets are invested. Contributors to a donor advised fund make irrevocable contributions to a nonprofit organization that administers the fund and makes decisions regarding fund investments. Contributors may recommend eligible charities as recipients for grants, but the fund’s governing body is free to accept or reject any recommendation.

4. What is the difference between a private foundation and a public charity?

The Foundation Center defines a private foundation as a nongovernmental, nonprofit organization having a principal fund managed by its own trustees or directors. Private foundations maintain or aid charitable, educational, religious, or other activities serving the public good, primarily through the making of grants to other nonprofit organizations.

To understand what a private foundation is, it helps to understand what it is not. Every U.S. and foreign charity that qualifies under Section 501(c)(3) of the Internal Revenue Service Code as tax-exempt is a “private foundation” unless it demonstrates to the IRS that it falls into another category. Broadly speaking, organizations that are not private foundations are public charities as described in Section 509(a) of the Internal Revenue Service Code.

Another difference between private foundations and public charities is that public charities generally derive their funding or support primarily from the general public, receiving grants from individuals, government, and private foundations. Although some public charities engage in grantmaking activities (see information and resources below on grantmaking public charities), most conduct direct service or other tax-exempt activities. A private foundation, on the other hand, usually derives its principal fund from a single source, such as an individual, family, or corporation, and more often than not is a grantmaker. A private foundation does not solicit funds from the public.

Not every organization that uses the word “foundation” in its name is a private foundation, and the word “foundation” has no legal meaning in and of itself. Instead you must look at how the IRS designates an organization and inquire as to whether they file a Form 990-PF (the tax return filed by private foundations) or a Form 990 (the tax return filed by public charities and other nonprofit organizations).

5. How may foundation assets be used? Donations to a private foundation may only be used for charitable purposes and certain administrative expenses.

6. Can I or members of my family be employed by my foundation? Yes. By appointing children or other family members as officers or directors, you will have the option of making the foundation a family affair. However, paying yourself or family members requires strict adherence to detailed IRS rules. To avoid the potential for legal problems, you must consult with your attorney before paying yourself or family members.

7. Can my family or I engage in transactions with the foundation? The IRS strictly prohibits self dealing. Disqualified individuals (the donor, lineal descendants and antecedents, e.g., parents, children and their spouses, and people under their employment) may not engage in transactions with the foundation except to make donations to it, or under limited circumstances, to receive fair market value compensation for services. Examples of self dealing include:

* Purchasing items from or selling items to the foundation.

* Personal use of foundation assets or income.

* Borrowing money from the foundation.

* Retaining foundation assets (e.g., paintings) on private premises.

8. Who can a private foundation give money (make grants) to? Private foundations typically carry out their philanthropy by making grants to recognized public charities. This includes churches and synagogues, educational, scientific and cultural institutions, poverty relief agencies or any other organization that qualifies as a 501(c)(3) charity according to the IRS. In some instances, a private foundation may provide grant money to individuals in the form of scholarships or grants for a particular project such as a art grant.

Private foundations are generally precluded from making grants to political campaigns or organizations that exist to influence legislation and voting.

9. Is there a minimum or maximum amount a private foundation must give away each year? The IRS requires that private foundations pay out at least 5% of the previous year’s average net assets for charitable purposes. This can include certain administrative expenses. There is no maximum limit on giving.

10. What types of organizations can a private foundation make grants to? Private foundations can give to any organization recognized by the Internal Revenue Service as a public charity. This includes churches and synagogues, educational, scientific and cultural institutions, poverty relief agencies or any other organization that qualifies as a 501(c)(3) charity according to the IRS.

11. How does a nonprofit supporting organization, compare to a private foundation?

A supporting organization is actually a private foundation as well, but it is treated, for tax purposes, as a public charity. This is because, under the tax law, it is so closely connected to at least one public charity that it is almost a part of that organization. The connection can be achieved by having a majority of the Foundation’s board appointed by the public charity. Or, the purpose of the Foundation can be to support specific projects of the public charity, in such amounts that the government can be reasonably assured that the public charity will be supervising the activities of the Foundation. The special tax status is granted because Congress is comfortable that the public will be protected, through the oversight and control by a public charity. Be careful, here, however, because the IRS has increasingly scrutinized both the applications of new supporting organizations, and their operations, just to be sure that there is such active oversight and control.

12. What are the penalties for failing to make the 5% payout within the designated time period?

Failure to make the 5% minimum payout results in a penalty equal to 15 percent of the remaining amount of the total payout that was not distributed as required. Remember, though, that this 5% payout requirement does not require payment during the first year of the foundation’s operation; while establishing yourself, you can defer grants into the second year – but not beyond (except under special set-aside rules).

13. Is it legal to compensate the trustees/board members of a charitable foundation?

Yes. Although the charity cannot exist for the significant benefit of a private individual, board service does involve devotion of time and expertise, for which individuals may be reasonably compensated.

The issue of “reasonable” compensation is a critical consideration. What comprises reasonable payments? The best guideline may be what other foundations in your area, with similar assets, do or do not pay their officers. This information is publicly available, as is federally mandated.

14. What is self-dealing and why is it illegal?

Self-dealing involves a direct or indirect transaction (generally a financial transaction) between the foundation and a “disqualified person” – even if the transaction would benefit the foundation. Self-dealing also includes any use of foundation income or assets by a private foundation for the benefit of a “disqualified person.” The self-dealing rules are outlined in Internal Revenue Code Section 4941 and were created to prevent misuse of foundation funds and assets for the personal gain of officers/directors and their friends or family.

Disqualified persons include, among others:

Foundation trustees, directors, managers, or officers;

Substantial contributors to the foundation;

An owner of more than 20% of any business that is a substantial contributor;

Members of the family of any of the above, including spouses, children, grandchildren, great- grandchildren, parents, other ancestors, or spouses of children, grandchildren or great-grandchildren;

Any corporation in which more than 35% of the voting power is owned by disqualified persons; and

Certain government officials.

Prohibited transactions include:

The sale, exchange or leasing of property (e.g. purchasing office supplies, printing or insurance from a disqualified person);

The lending of money or extensions of credit;

The furnishing of goods, services or facilities for money;

The transfer of, or use of the income or assets of a foundation for the benefit of a disqualified person; and

Foundations are organized under state law and are generally established in the state where the foundation intends to do business. Unless laws vary drastically from IRS regulations in your state, generally, there is no need to state-shop when setting up a foundation. If the foundation is incorporated in one state but has a primary office in another state, the law requires that you file annually in both states.

2) What type of foundation?

Private/Independent/Family Foundation: The IRS classifies an organization as a private foundation rather than a public charity when its funding comes from limited sources – an individual, a family, a corporation, or a small group of donors – rather than major support from the general public. The terms private and independent are often used interchangeably with the term family foundation. Family foundations are usually organized in the form of a nonprofit corporation or a trust and the bulk of the budget is usually made up of grants to other charitable organizations.

Private foundations have more autonomy and flexibility that other types of foundations. For example, directors are not subject to constant review by the organization’s members and are not responsible to shareholders. Private foundations are governed by different legal regulations than public charities and are required to pay a tax on investment income and make charitable expenditures that equal or exceed 5 percent of their endowment.

Company/Corporate Foundation: This model is subject to the same rules as a private foundation but the source of funds is a for-profit company. It usually has a small endowment allowing for a reserve during low-profit years, funds pass through the foundation, and grants made generally come from charitable contributions of the for-profit company in the same year.

Pass-Through or Conduit Foundation: A private, nonoperating foundation usually established by a donor during his/her lifetime to establish governing rules in anticipation of a large future bequest. Donors may take advantage of more liberal charitable deduction rules, no gifts may be used to build an endowment and all contributions must pass through the foundation no later than two and a half months after the end of the tax year in which the gifts are made.

Pooled Common Fund: In this model, one or more donors may make contributions that are pooled into a common fund. A donor (or donor’s spouse) may retain the right to designate annually which organizations will benefit from income from donor’s contributions. All recipients of funds must be public charities as defined in Section 509(a)(1) of the tax code. The fund’s governing instrument must provide for distributions and in fact pay out all adjusted net income after certain other requirements are met.This model also provides the donor with substantial control over distribution of funds and donors are subject to more liberal charitable deduction rules.

Operating Foundation: Directly operates its own charitable program (i.e. running a museum) instead of making grants to other charitable organizations. Donors may take advantage of more liberal charitable deduction rules and the foundation generally must spend at least 85 percent of its investment income directly for the operation of its charitable activities. Other regulations apply (see article).

3) Will the foundation be established as a charitable trust or in corporate form?

Many donors choose to establish a charitable trust because it is simple to create and generally does not require approval by a governmental agency. The law of trusts is based on common laws and is therefore more flexible and less precise than the laws of incorporation. Trusts also have more flexibility in receiving and disposing of real property than nonprofit corporations.

On the other hand, a nonprofit corporation provides greater protection from liability for directors. Directors of a nonprofit corporation are held to less stringent fiduciary standards than trustees of a trust. Delegation of investment decisions, enlarging the governing board or replacing board members may also be handled more effectively in the corporate form.

4) How do I incorporate?

If you choose to incorporate, the foundation’s proposed name should be cleared with the state, and a “certificate of incorporation” or similar document must be prepared in accordance with state laws. The federal requirements for exempt status as a private foundation demand that the certificate include:

language establishing its charitable, educational or similar purpose in the purpose clause;

a statement that the earnings of the corporation shall not result in any private benefit to its members, trustees, or officers (except for reasonable compensation for personal services rendered);

a statement that no substantial part of the corporation’s activities shall consist of attempts to influence legislation (except where that legislation may affect the foundation’s operation) and that it shall not participate in political campaigns;

a clause providing that on dissolution the assets shall be disposed of for charitable purposes;

a statement that the corporation will comply with the requirements of Sections 4941, 4942, 4943, 4944, and 4945 of the Internal Revenue Code.

Note: Many purpose clauses are drafted in general language to simplify the process of obtaining tax exemption and to allow the governing board flexibility to modify policy in the future. The purpose clause should be drafted with more specificity if the donor’s intent is to make sure that the foundation adheres closely to particular charitable purpose.

5) Will the foundation created have a limited life or perpetuity?

Most states give perpetual life to corporations created by statute while providing ways for their members and others to terminate them. In most states, trusts created for the benefit of charity can exist in perpetuity. Some donors choose to limit the foundation’s life to a term of years, at the end of which all assets must be distributed.

Following are some issues that must be considered in determining the life of the foundation: Is the foundation’s charitable purpose an area with limited life or one that can be funded in perpetuity? Will work be carried on by future generations or is it something the donor wants to end at a particular point in time? Will the initial endowment carry into the future? Will the foundation raise funds to add to the endowment? Will the foundation set up an investment policy to increase the endowment, or will the intent be for initial endowment to be disbursed, and the foundation dissolved upon final disbursement?

6) What will the governing body look like?

Once a foundation is established, the donor must decide the size, make-up, method of election, and tenure of its governing body. Specifics of the governing body may be outlined in the foundation’s bylaws rather than in the certificate of incorporation because they will be easier to change. The bylaws should contain authorization for appointing committees of the board, electing officers, notice and waiver of notice of meetings, and similar provisions addressing the foundation’s administration. Basically, they should make clear that the board has authority to run the foundation.

7) What is an organizational meeting?

Under state law, corporations generally hold an initial meeting to: elect director(s) and officers, adopt the corporation’s bylaws, pass a resolution to open bank accounts and sign signature cards, establish the fiscal year, adopt a corporate seal, provide for recruitment of initial or interim staff, record the minutes of this meeting and file them with subsequent meeting minutes to be kept for the life of the foundation. This meeting can be held as soon as the state has approved the foundation’s certificate of incorporation, thus making the foundation a legal entity.

8) How do I file for Exempt Status with IRS?

Upon receiving the certificate of incorporation and adopting bylaws, the foundation can seek exemption from federal income tax. This will assure that contributions to the foundation are tax deductible. A Form 1023 must be filed with the appropriate IRS district within fifteen months of the foundation’s organization under state law. When granted, IRS recognition of exempt status will then be retroactive to the date of organization.

In addition to the Form 1023, a foundation must file for an employer identification number on Form SS-4 (this is necessary whether or not the foundation intends to hire employees). After filing Form1023, the foundation waits for a determination letter from IRS (generally a few months). In the meantime, the foundation must file a Form 990-PF with IRS and state authorities on or before the due date as if the federal tax-exempt status has been determined.

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